Benchmarks Turned Emerging Markets Into a Giant Blob

Investors have done little to differentiate 'risk premia' in recent years.

Here's Why Investors Are Worried Over Emerging Markets

"The Fragile Five," is a term coined by a Morgan Stanley analyst named James Lord back in 2013, as he attempted to describe the emerging market economies most prone to flighty foreign investors.

A former International Monetary Fund economist later suggested "The Sorry Six," which would have added Russia to the original mix of Turkey, Brazil, India, Indonesia and South Africa. Meanwhile, Deutsche Bank analysts proffered up the questionable "Biits" to encapsulate the same group.

Those are but three of the more recent examples of the long-running trend towards singling out emerging market economies, either for their latent promises or growing vulnerabilities. Perhaps the most prominent example of this historic tendency is the "Brics" designation dreamed up by Goldman Sachs economist Jim O’Neill in 2001 to describe the booming EM economies of Brazil, Russia, India, China, and South Africa.

A new working paper from the Bank for International Settlements casts doubt on the extent to which investors actually differentiate between emerging market economies, at least in the form of risk premia—or the extra returns demanded by investors to compensate them for added risk—as measured by credit default swap (CDS) spreads.

The analysis suggests that for the past six years, investors have herded into the EM asset class largely based on benchmarks rather than country-specific factors.

The authors look at two distinct periods, namely before the financial crisis and after, to gauge whether the turmoil of 2008 brought about a "new normal" in investors' attitudes towards emerging market economies.  They then segment two "driving forces" of risk premia, the first being global drivers of risk appetite and the second being economic fundamentals such as debt-to-GDP ratios, or fiscal and current account balances. 

You can see their findings summarized in the below pie charts. The pie on the left shows the first factor of global risk appetites accounting for about half of the variation in emerging market CDS returns in the run-up to the financial crisis. After 2008, these global forces become decidedly dominant, explaining more than three-fifths of the variation in returns.

Source: BIS

"When it comes to how the different countries load on this factor, we find that that the commonly cited economic fundamentals have little influence on the country-specific loadings on the factor," note the authors Marlene Amstad, Eli Remolona, and Jimmy Shek. "Instead the single most important explanatory variable for the differences in loadings is a dummy variable that identifies whether or not a country is an emerging market."

It's worth re-emphasizing here that the study focuses on CDS spreads alone. A look at capital flows—or the actual movement of money in and out of EM economies—will likely show something very different. Previous research for instance,  found "global push factors" driving capital flows in 2008 but country-specific "pull factors," dominating from 2009 to 2010. Still, they bear relevance as markets move to rapidly reprice their risk assumptions of emerging market economies; the MSCI Emerging Markets Index has fallen 27 percent over the past year alone.

"In the end, we find that CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of 'emerging market,'" the authors write.

In other words, 'The Fragile Five,' 'The Sorry Six,' et al, never existed in terms of CDS spreads.

"While the emerging markets designation may serve to summarize many relevant features of sovereign borrowers, it is a designation that lacks the kind of granularity that we would have expected for a fundamental on which investors’ risk assessments are based," the authors add, rather delightfully.

As for what might account for the en masse move in EM risk premia, the authors point to the rise of index-based investing and the post-crisis dominance of large asset managers seeking to meet their benchmarks. Not discussed is the general compression of risk premia experienced in the wake of easy monetary policies implemented around the globe following the financial crisis.

"The importance of the emerging markets designation in the new normal suggests that index tracking behavior by investors has become a powerful force in global bond markets," the authors conclude.

"For the most part, when global investors invest in emerging markets, instead of picking and choosing based on country-specific fundamentals, they appear to simply replicate their benchmark portfolios, the constituents of which hardly change over time."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE